What Is Commercial Property Depreciation and How Does It Work?
Whether you’re new to real estate or already building a portfolio, understanding how depreciation works in commercial real estate is essential to optimizing your investment strategy.
What Is Commercial Property Depreciation?
Commercial property depreciation is the process of deducting the value of a building (not the land it sits on) over time to account for wear, tear, and general aging. The IRS assumes that buildings don’t last forever and therefore lets you gradually recover the cost of the property through annual tax deductions.
This concept doesn’t reflect actual property value in the market—your building could be appreciating in price while still being depreciated on your tax return. It’s a paper deduction, but the tax benefits are very real.
Quick Summary:
Only the structure, not land, is depreciable
Standard depreciation schedule for commercial property is 39 years
Applies to buildings used for business or rental income (not personal residences)
Even if your property is increasing in market value, you can still depreciate it because the deduction is based on the structure’s theoretical useful life, not current market trends.
How Is Commercial Property Depreciation Calculated?
Depreciation sounds complicated, but the basic calculation is straightforward—especially under the most commonly used straight-line method, where the same amount is deducted each year.
Step-by-Step Process:
Determine Cost Basis: Add up the purchase price, closing costs, and any capital improvements. Don’t include land costs.
Allocate Land vs. Building: Use a reasonable method (such as tax assessor data or an appraisal) to determine how much of the total cost is land and how much is structure.
Apply the Depreciation Formula: For commercial real estate, divide the depreciable amount by 39 years (the IRS-designated useful life for non-residential properties).
Example:
You purchase a commercial building for $1 million.
Land is valued at $250,000 (non-depreciable)
Building value = $750,000
Annual depreciation = $750,000 ÷ 39 = $19,231
Each year, you can deduct $19,231 from your taxable income for 39 years—resulting in hundreds of thousands in potential tax savings over the property’s lifetime.
Benefits of Commercial Property Depreciation for Investors
The power of commercial property depreciation lies in its ability to lower taxable income without affecting cash flow. This makes it an especially valuable tool for buy-and-hold investors.
Key Benefits:
Tax Savings: Annual depreciation reduces your taxable income, potentially pushing you into a lower tax bracket.
Higher Cash Flow: Because depreciation is a non-cash expense, it doesn’t reduce the actual income you receive—only what the IRS sees as profit.
Offsetting Other Income: In some cases, depreciation losses can be applied to other income sources, further reducing your overall tax bill (subject to passive activity loss rules).
Long-Term Investment Strategy: By combining appreciation, rental income, and depreciation, investors create multiple streams of return from a single asset.
Practical Example:
Let’s say your building earns $60,000 in net rental income annually. After depreciation of $19,231, your taxable income drops to around $40,769. If you’re in the 24% tax bracket, that’s a savings of $4,615 per year—just from depreciation.
Understanding Cost Segregation in Commercial Real Estate
While the 39-year schedule works well, savvy investors often take things a step further with cost segregation—a method of accelerating depreciation by separating components of a building that have shorter useful lives.
What Is Cost Segregation?
Cost segregation breaks down your commercial building into categories like:
Personal property (e.g., carpeting, lighting systems) – depreciated over 5 to 7 years
Land improvements (e.g., parking lots, landscaping) – depreciated over 15 years
Structural building – depreciated over 39 years
Why Use It?
The goal is to front-load your depreciation deductions, creating larger tax benefits in the early years of ownership. This is especially helpful for investors looking to reinvest that saved cash into additional properties.
Real-World Impact:
A cost segregation study on a $1.5 million building might reclassify $300,000 worth of assets into 5, 7, or 15-year categories, resulting in $50,000 or more in extra deductions in the first year alone.
It’s a complex process, usually handled by specialists, but it can yield incredible savings that far outweigh the cost of the study.
Tax Implications and Depreciation Recapture
Depreciation offers great tax benefits—but when it’s time to sell, there’s one crucial rule to understand: depreciation recapture.
What Is Depreciation Recapture?
The IRS wants to recover some of the tax savings you received over the years. When you sell a depreciated property, the portion of the gain attributable to depreciation is taxed—up to a 25% rate.
How It Works:
You bought a building for $800,000 and claimed $200,000 in depreciation.
You sell it years later for $1 million.
The IRS “recaptures” the $200,000 at a higher tax rate than capital gains.
How to Minimize It:
Use a 1031 Exchange to defer capital gains and depreciation recapture taxes.
Keep good records of all improvements, which can help reduce the gain.
Being proactive with your tax strategy and consulting a real estate CPA can help you avoid a surprise tax bill.
Conclusion
Commercial property depreciation is a powerful, often underutilized tool that can turn a good investment into a great one. From annual tax deductions and improved cash flow to advanced techniques like cost segregation, mastering depreciation allows you to maximize returns while minimizing taxes.
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Frequently Asked Questions
Can Land Be Depreciated Along with Commercial Property?
No, land cannot be depreciated. The IRS considers land to have an indefinite useful life, so it’s not subject to depreciation. Only the structures and improvements on the land can be depreciated.
If you purchase a property, it’s important to allocate the cost properly between land and building to avoid misreporting depreciation.
What Happens to Depreciation if I Renovate My Commercial Property?
Renovations or capital improvements create new depreciation opportunities. Rather than adjusting the original building’s schedule, improvements are typically added as new depreciable assets with their own useful lives.
For example:
A new HVAC system might be depreciated over 15 years
A roof replacement might follow a 27.5 or 39-year schedule depending on its classification
Always distinguish between repairs (immediate expense) and capital improvements (depreciated over time). A tax professional can help categorize these correctly.
Do I Need a Professional to Handle Commercial Property Depreciation?
You can calculate basic straight-line depreciation yourself, but if you want to maximize tax benefits—especially through cost segregation or capital improvements—it’s highly recommended to work with professionals.
CPAs with real estate experience can ensure accurate reporting
Cost segregation firms specialize in maximizing depreciation early on
Tax attorneys can guide you through complex issues like depreciation recapture or 1031 exchanges
The right team can save you far more in taxes than their services cost, making professional help a smart long-term investment.
